the nealon manufacturing co

Project Description:

the nealon manufacturing company is in the midst of negotiations to acquire a plant in fargo, north dakota. the company cfo, james nealon, is the son of the founder and ceo of the company and heir-apparent to the ceo position, so he is very concerned about making such a large commitment of money to the new plant. the cost of the purchase is $40 million, which is roughly one-half the size of the company today.

to begin his analysis, james has launched the firm's first ever cost of capital estimation. the company's current balance sheet, restated to reflect market values, has been converted to percentages as follows:

nealon, inc., balance sheet – 2013

types of financing ................................................................................. percentage of future financing
bonds (8%, $1,000 par, 30-year maturity) ............................................................... 38%
preferred stock (5,000 shares outstanding, $50 par, $1.50 dividend) .................... 15%
common stock ........................................................................................................ 47%
total ........................................................................................................................ 100%

the company paid dividends to its common stockholders of $2.50 per share last year, and the projected rate of annual growth in dividends is 6% per year for the indefinite future. nealon’s common stock trades over-the-counter and has a current market price of $35 per share. in addition, the firm's bonds have a aa rating. moreover, aa bonds are currently yielding 7%. preferred stock has a current market price of $19 per share.

a. if the firm is in a 34% tax bracket, what is the weighted average cost of capital (i.e., firm wacc)?

b. in the analysis done so far we have not considered the effects of flotation costs. assume now that nealon is raising a total of $40 million using the above financing mix. new debt financing will require that the firm pay 50 basis points (i.e., one-half a percent) in issue costs, the sale of preferred stock will require the firm to pay 200 basis points in flotation costs, and the common stock issue will require flotation costs of 500 basis points.

i. what are the total flotation costs the firm will incur to raise the needed $40 million?

ii. how should the flotation cost be incorporated into the analysis of the $40 million investment the firm plans to make?
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